otc trading - impact of ccp cognizant white paper

OTC Trading: Impact of The CCP ModelRecent trends in the OTC Trade scenario & key impacts for Market participants under the new CCP model

• White Paper

Executive Summary

Following the global financial crisis, there has been

much investigation by regulatory agencies as to the

causes. Over The Counter derivatives (OTC) are very

profitable for financial firms but have been identified

as one of the potential causes. As part of the

corrective action, the common agreement has been

to move the OTC trading system to a Central Clearing

Party (CCP) platform. In the new approach, bilateral

contracts between two counterparties will not exist.

The CCP would become the intermediary. The seller

would sell the contract to the CCP and the buyer would

buy the contract from the CCP. This will introduce

an effective monitoring conduit as the CCP can

stipulate the required collateral and monitor

effectively the positions of the two parties under the

new regulatory changes.

This paper outlines the background need for OTC

derivatives and the objective for CCP clearing. It then

takes a look at the type of CCP models that are evolving

in the market. They can be established as a ‘no profit’

platform under the ownership of market participants

or they can be run on a profit basis while being

monitored by the regulator. They also differ based on

their capital / margin requirements for new members,

vital infrastructure and the basic clearing process

flow. There are stringent membership requirements

for CCP that have led to the development of a new

service called Client Clearing, which extends the

benefit of clearing services, through CCP members,

to participants who are not members of the

CCP. A comparison between the traditional OTC

trade model and the new trade flow under the CCP is

outlined later in this paper.

The trends in the OTC industry under this new

regulatory environment, and the impact of the CCP

platform are discussed in detail. A key focus of the

paper is to explain at a more granular level, the impact

that the OTC derivatives clearing will have on market

participants and the changes and enhancements they

will need to make to internal processes in order to

serve themselves and their clients efficiently.

Introduction: The Need for Central Counterparty Clearing

The OTC Derivatives market is dominated by a few

large financial institutions.

The class of instruments known as Derivatives covers

a wide range of instruments many of which have been

standardised and traded on stock exchanges for more

than a couple of decades. Such derivative instruments

include futures and options with various underlying

asset classes such as equities, fixed income and

currencies. These asset classes have traditionally

been very liquid and as a result their corresponding

derivatives are easily standardised. The traditional

exchange traded derivatives are well served to

transfer market risk among participants.

However, instruments that transfer other kinds of risk

such as credit risk and interest rate risk have proved

difficult to standardise for the following reasons:

Derivative instruments by their nature require two

participants to take an opposing view on a certain

underlying asset. It is easy to find a counterparty who

takes an opposing view on the direction of an equity

or the direction of the credit spread of the issuer of a

bond because these risks are easily perceived based

on a few parameters. However, in the case of interest

OTC Trading White Paper | March 2011

OTC Trading White Paper | March 2011 2

rate risk, it is not sufficient for the counterparty to

take a view on just a few parameters. The valuation of

interest rate derivatives is a function of the frequency

of payments, the particular floating rate involved

and the entire yield curve rather than just a single

interest rate. Similarly, valuation of credit derivatives

is complex because of the difficulty in estimating the

probability of default, and standardisation is difficult

due to the various kinds of default events possible.

As a result, trades in complex derivative transactions

are low. However that does not mean that these

derivatives do not fulfill a need. For instance a

bank that has long term floating rate liabilities

may well want to hedge their interest rate risk. The

transaction adds value to this party, although finding

a counterparty may be difficult as it would be rare

for another party to have the exact opposite hedging

requirement. The role of market makers has thus

become key for the non-exchange traded Over the

Counter (OTC) derivatives market. This means that

certain large financial institutions with enough capital

are offering to enter into such transactions (in either

direction) with end users who want to hedge their risk.

These market makers hedge their own risk either by

transacting with another end user or with another

market maker in the opposite direction.

Challenges that arise due to market dominance by a

few large banks

The OTC derivatives market is dominated by a few large

banks. Although the role of these institutions resolved

the issue of liquidity and ease of finding counterparty

members, it also introduced the following problems:

1. A few banking institutions emerged as the

counterparties for over 90% of the overall OTC

trade transactions. These banks were independent

entities with several lines of businesses other

than simply market making. Many of these lines of

business involved active risk taking on the banks’

proprietary books. If any of these banks became

insolvent, it meant that a significant proportion

of OTC trades would be defaulted on. As the large

banks also had a lot of OTC trade volumes among

themselves (for hedging purposes), default on

the part of one bank also impacted other market

makers. To make matters worse, unlike standard

exchange trades, OTC trades were not regulated

and there were no authentic estimates on the

volume of trades that each bank was involved in,

and therefore no estimate of the impact on the

market that a default by a market maker may

cause. Thus in the absence of any regulation,

market makers themselves had very little idea on

how much risk they were exposed to by way of

exposure to other market makers.

2. OTC trades by definition were not traded on

exchanges and hence the sole responsibility

of settling the trades was with the two parties

involved. This meant that market participants

especially the banks, had to maintain bilateral

clearing relationships and legal agreements with

numerous other parties. Lack of standardisation

for clearing agreements meant slow paperwork.

Additionally, bilateral clearing relationships meant

that whenever trades were marked to market, the

party in the money would collect collateral from the

other party in order to mitigate the risk of default.

A typical market making bank would have clearing

relationships with numerous clients and would

therefore need to maintain collateral payment

processes with each party. Such bilateral clearing

relationships had one significant disadvantage.

The collateral collected by parties from other

counterparties was not typically segregated from

the party’s own assets and hence if any party went

bankrupt, the counterparties who had deposited

collateral with the bankrupt parties typically could

not recover their collateral.

Need for central counterparties

To mitigate the above disadvantages of bilateral

clearing, central counterparties have now emerged

to facilitate clearing of OTC derivative trades.

Central counterparty clearing involves every trade

between two participants getting intermediated

by the clearing house, so that the clearing house in

effect becomes the counterparty for both the original

trade participants. This approach has the advantage

of requiring fewer clearing relationship agreements

(each party with the clearing house) but also allows

trade participants to mitigate their counterparty

credit risk. The counterparty credit risk is mitigated

because the clearing house is the only counterparty

for trade participants and it is a firm which does not

indulge in taking active risk onto its books through

other lines of businesses.

Variations Among The Clearing Houses

Although this seems like panacea for the OTC market,

it is now imperative that the risk of default by the

clearing house itself is mitigated to the maximum

degree possible as it is counterparty for every market

participant, and a default will have a catastrophic

impact on the market. The two most popular clearing

house business models are:

1. Not for profit – owned by participants: Such a

business model involves the clearing house being

owned by the major market participants (banks

which are the market makers) so that the protection

layer for the clearing house is the capital infused

by these participants. As such, the cost of this

infused ‘protection’ capital can be thought of as a

cost borne by the major market makers to mitigate

the risk of clearing house default, and therefore

facilitate a healthy market which is key to their

market making business.

2. For Profit – monitored by the regulator: The clearing

house, if privately run, will be a For Profit entity. The


risk of default is mitigated by way of regulation which

mandates a certain threshold of capital requirement

and also restricts the clearing house from deploying

its funds in any kind of active risk strategy. In this

model, the cost to market participants is charged

through higher transaction costs.

Different clearing houses differ in the services

provided although all fulfill the basic purpose

of providing CCP services. One of the major

differences is the type of products supported

by the clearing house. For instance, the below

table shows products supported by various

different CCPs.

Currently operational Over the Counter Deriviative Central Counterparties

Source:IMF staff. 1Other includes commodities, energy, freight, and macroeconomic (e.g. inflation) indicators.

Additionally, clearing houses may differ on factors

such as:

1. Membership eligibility criteria: This criteria usually

relates to capital requirements that a prospective

member needs to satisfy. Failure to meet these

requirements would mean that the participant

cannot be a member of the clearing house and can

only clear their trades through that clearing house

only through another member and only in the

event that the clearing house offers client clearing

services (described in the next section).

2. Margin requirements: This refers to the

methodology used by clearing houses to calculate

margin requirements for trades that are cleared.

Initial margin requirements vary by product

and also by clearing house due to different

methodologies adopted.

3. Key infrastructure: This includes connectivity

to ECNs, trade repositories, real time or batch

processing, reporting capability. Infrastructure

supported by a clearing house is a feature of key

importance to prospective members, as that dictates

the mode in which they would have to conduct their

trades and build their internal processes.

4. Workflow for the clearing process: The workflow

followed in the clearing process differs across

clearing houses. For instance, London Clearing

House (LCH) clears the trade after the Clearing

Broker has stepped into the trade between the

Client and the Executing Broker. CME Group Inc.

is the world’s largest futures exchange and has,

on the other hand, proposed that both Client and

Executing Broker will have their own Clearing

Brokers and the Clearing Brokers will be informed

of the trade after the Clearing House has agreed

to clear the trade. The way in which allocations are

handled by Clearing houses also differs. In the LCH

workflow, a block trade is one where the Clearing

Broker steps in and the child trade splits are later

individually cleared by the Clearing house. On CME,

the client can choose a different clearing broker for

each split and each split proceeds independently

through the clearing process right from the onset.

ContactType

Platform(Domicile) Interestrateswap CreditDefaultswap Foreignexchange Equitities Other1

CME Clearing (U.S) ✓ ✓

BM&FBovespa ✓ ✓ ✓ ✓

Eurex Clearing AG (Germany) ✓ ✓ ✓ ✓

Euronext/LIFFE BClear (U.K.) ✓

ICE Clear Canada (Canada) ✓

ICE Clear Europe (U.K.) ✓ ✓

ICE Trust (U.S.) ✓

LCH. Clearnet U.K.) ✓ ✓

LCH. Clearnet SA (France) ✓

IDCG International Deriativatives

Clearinghouse (U.S.) ✓ ✓

NASDAQ OMX Stockholm AB (Sweden) ✓

NOS Clearing (Norway) ✓

SGX Asia Clearing (Singapore) ✓


Client Clearing

A typical central counterparty platform will only

intermediate trades where both participants are

members of the clearing house (CCP). This is because

the CCP needs both participants to deposit initial

margin and then pay or receive variation margin to

either party daily, depending on the Mark to Market

(MTM) value of the trade. The CCP therefore needs to

have a clearing relationship with all parties. This basic

approach however meant that a trade between a CCP

member and a non-CCP member could not be cleared

by the CCP. Most buy-side firms are not CCP members

and therefore could not benefit from the advantages

of a CCP. In recognition of this, certain clearing houses

(LCH Clearnet for example) have started offering a

relatively new service called Client Clearing.

To illustrate an example of a Client Clearing workflow,

we look at how LCH offers this service. The exact

process may differ for other clearing houses but

the concept remains the same. Client clearing at

LCH refers to the process of a central counterparty

stepping in to clear the trade between a Bank and

a client (bank vs. client). This process differs from

clearing of interbank trades because clients are not

typically members of LCH.

In the LCH Client Clearing process, the CCP first steps

in between the bank and the client. However, since

the client is not a member of the clearing house, the

client and the CCP cannot face each other directly in a

trade. Therefore, the Clearing Broker (CB) again steps

in between the CCP and the client.

The above process results in two more trades (referred

to hereafter as BacktoBack trades) getting created in

addition to the bank vs. client:

1. Bank vs. CCP (on the Bank’s House CCP account)

2. CCP vs. Bank (on the Bank’s Client CCP account)

This process provides the client the same level of

protection from counterparty credit risk as enjoyed

by members of the LCH in an Interbank trade. This is

the process termed as Client Clearing.

Note that the original Primary trade was between the

Executing Broker (EB) and the client, and after the

EB gave up the trade to the Clearing Broker (CB), two

trades had resulted: CB vs EB and CB vs. client.

The CB vs. EB trade is an Interbank trade and post

clearing at LCH, resulted in two trades getting created

CB vs. LCH and EB vs. LCH. The CB vs. Client trade

goes through the process of Client Clearing as

described earlier and results in three trades.

Thus, an initial Primary trade between the Executing

Broker (EB) and the Client finally results in five trades

getting created. The trades evolve in the following

manner:

Step 1. Primary trade

a. Client vs. EB

Step 2. Secondary trades post give-up by EB

a. Client vs. CB

b. CB vs. EB

Step 3. Trades created post clearing of the two

Secondary trades

a. Client vs. CB

b. CB vs. CCP (CB’s Client CCP account;

as related to the Client vs. CB trade)

c. CCP vs. CB (CB’s house CCP account;

as related to the Client vs. CB trade)

d. CB vs. CCP (CB’s house CCP account;

as related to the CB vs. EB trade)

e. CCP vs. EB (not reflected in the CB’s

internal systems; related to the CB vs. EB

trade)

The end state of each entity (EB, CCP and client) and

the direction of the trades and path of collateral flow

can be depicted as shown below:

Executing Broker

HouseAccount

Clearing Broker

HouseAccount

ClientAccount

ExecutingBroker

ClearingBroker

Client

EB trade

Client trade

Flow of collatoral

LCH Clearnet


Traditional And The New CCP Model – A Comparison

TRADITIONAL MODEL

Party A(Buy Side)

Sign ISDA Master Agreement

Executing Platform Inter Dealer Brokers (IDB)

Middleware Trade/Post Trade EventsMatching & Confirmation

Markit WireIcelink

Trade Details

Trade NegotiationTrade Negotiation

Settlement MemberAccount (Party A)

DTCC Trade Information Warehouse (TIW)

Information RepositoryPayment Calculation & Bilateral Netting

Coupon PaymentCredit Event Payment

Continuous Linked Settlement (CLS) Bank

Multi-lateral Netting

Trade CompressionTriOptima

Trade DataMatched Trades

Trade Details

Reconciliation/Reports

MatchedTrades

Payment

Trade Data forCompression

Compressed Trades

Markey DataMarkit, SwapsMonitor, Reuter and Bloomberg

Party A(Buy Side)

Party B(Executing Dealer)

Settlement Member Account (Party B)

TradeData

Trade Details

Payment

Payment Instructions

MarketData

PaymentInstructions

Payment

Merge Payments

Margin Call

Merge Payments

Margin Call

Market Data

PaymentInstructions

(for CLS Members)

Market Data

Trace Data

International Swaps and Derivatives Association (ISDA)

Publishes Master Agreements for OTC DerivativesPublishes Credit Events

Regulators

Securities and Exchange Commission (SEC)Financial Services Authority (FSA)

Bilateral Clearing

Large number of settlement transactions

Systemic ripple effect of an individual entity’s failure

High total Cedit exposure

Inadequate Collateral & Default Management

Uncollateralized OTC exposures

Lack of standardized defaultManagement process

Unilateral collateral workagainst weaker counterplayif the stronger defaults

Trade repository notmandatory

Lack of transparency inreporting trade positions

Regulatory oversight impacted

Non Standardised method of valuing exotics and collateral

Disputes arise betweencounterparties when margin calls are made

* Represents the Credit Derivatives landscape


Party A(Buy Side)

Sign ISDA Master Agreement

Executing Platform Inter Dealer Brokers (IDB)

Middleware Trade/Post Trade EventsMatching & Confirmation

Markit WireIcelink

Central Counterparty Clearing (CCP)Novation

Multilateral NettingRisk & Default Management

Payment CalculationSettlement

(ICE/CME/EUREX)

Party B(Executing Dealer - Non CM)

Trade Details

Trade Details with DCM Information

Trade Negotiation

Trade Data

CCP EligibleTrades

CCP AcceptedTrades

Trade Negotiation

Designated Clearing Member(For Party A)

Risk ManagementCollateral ManagementCompliance Reporting

Designated Clearing Member (For Party B)

Risk ManagementCollateral ManagementCompliance Reporting

Settlement Bank(DCM A)

DTCC Trade Information Warehouse (TIW)

Information RepositoryPayment Calculation &

Bilateral NettingCoupon Payment

Credit Event Payment

Continuous Linked Settlement (CLS) BankMulti-lateral Netting

Settlement Bank(DCM B)

Trade CompressionTriOptima

Trade Execution&

Trade Matching

Clearing

Trade InformationWarehouse / Settlement

Trade Data Trade Data

Matched Trades Matched Trades

Trade Details with DCM Information

Reconciliation/Margin Reports

Reconciliation/Margin Reports

CCP AcceptedTrades

Payment Instructions(For CLS Members)Payment

CCP AcceptedTrades

Compressed Trades

Payment

Markey DataMarkit, SwapsMonitor, Reuter and Bloomberg

Payment Instructions

Market Data

Market Data

Margin Payment

Initial/VariationMargin

Trade Data

Initial/VariationMargin

Margin Payment

Market Data

Changes in newCCP model

Notes 1. Coupons Payments and credit event payments for CDS are usually settled through CLS. Margin Calls are directly settled by CM with CCP through designated banks.2. CME however uses its own infrastructure for settlement and just sends the trade details to Trade Information Warehouse (TIW).3. CCP uses the DtCC link to CLS for its settlements.4. For IRS, trades are mostly cleared through LCH Clearnet’s swap clear service. Settlements are through BOE (GBP & Euro), Citibank (USD), HSBC (Other currencies).

The limitations in the traditional model are addressed by some legislative actions as follows -

Regulations Description ProposedBy

CCP Clearing All standardized derivatives must be cleared by a clearing house Dodd Frank /UK/G-20

Exchange Trading -OTC All CCP cleared trades have to be executed via an exchange or swap exchange facility(SEF) with multiple participants posting bids and offers. Dodd Frank /UK/G-20

Post Trade Transparency All OTC trades must be reported to a central repository. Dodd Frank /UK/G-20

Position Limits Dodd Frank Act mandates CFTC to impose position limits across different markets, including energy, agriculture and certain OTC derivatives Dodd Frank

Reporting Large Hedge Funds and Private Equity Funds to register with SEC and report trading activities, positions etc of OTC trades Dodd Frank

Regulatory coordination Setting up of the OTC Derivatives Regulatory forum in Sep 2009 to formulate a global approach to regulate OTC derivative trades Global regulators

Capital requirements Higher counterparty capital charges imposed on banks and dealers on bilaterally cleared OTC transactions Basel/G-20

Stiff margin requirements for CCP Sufficient margin “to cover losses that result from at least 99 percent of price movements over an appropriate time horizon” ESCB/CESR

NEW CCP MODEL


Advantages of multilateral clearing with CCP

1. Reduced Credit Risk

a. Multilateral netting reduces overall exposure

b. Robust margining methodology & Collaterals

c. Cross margining benefit

d. Well defined default management procedure

2. Reduced Operational Risk

a. Automated operational procedures

b. Transparency in positions and collateral reporting

by independent entity

3. Reduced Systemic & Legal Risk

a. Multilateral netting reduces knock on failures

b. CCP access to central bank liquidity

c. Legal enforceability possible

Disadvantages of CCP

1. Risk of CCP failure

a. Concentration of risk at CCP – what if CCP fails?

b. Mutualization risk by CM

2. Standardization issues

a. Product complexity & valuation of illiquid products

b. ETD Risk management methodology may not be

equally effective for OTC

3. Interoperability between multiple CCP

a. Differences in Risk Management & Default

management approach

b. Lack of coordination in managing exposures

across CCPs

c. Absence of connectivity for transferring

information

Trend ImpactonMarketparticipants

Multiple clearing houses are offering OTC clearing services Clearing houses will need to develop risk management policies and a business model to mitigate the risk of their own default

Standardization of OTC derivatives products Need to ensure that their trading systems and internal tools can support the new product standards

Increasing number of products ‘Clearing Eligible’ Need to upgrade their internal processes so that they can reconcile their records with clearing houses and also provide reports to clients

Development of consolidated trade repository Currently DTCC trade warehouse acts as a repository for a large for increasing number of asset classes proportion of CDS trades. Other asset class trades are soon likely to have trade repositories where market participants will need to report their OTC trades (bilateral or cleared)

Default Management Procedures to be specified by CCPs Need to develop internal processes to deal with their obligations to the clearing house as well as to clients as Backup clearing brokers

Volume of post trade events on cleared trades Post trade events on cleared trades involve declearing and reclearing will increase as more OTC trades get cleared by CCPs of trades. Market participants need internal systems which can allow STP of these events

A large number of existing bilateral trades will be converted Need to develop internal processes for backloading old trades to Triparty clearing trades (processed through paper agreements) onto affirmation platforms (like MarkitWire) so that the trades can be cleared through the appropriate CCP

OTC trades sent to CCPs will be legally Need to deal with increasing volumes and therefore internal processes affirmed through electronic platforms such as Limit monitoring will necessarily be required to be done through automated systems rather than in a manual fashion by the middle Office personnel.

Volume of trades in complex products to increase Need to upgrade their internal risk management systems so that they as a result of CCP clearing of OTC trades are able to process exotic instruments

CCPs will perform a daily MTM valuation and impose Need to develop processes to monitor in real time the margin margin requirements on trade participants requirements of clients and themselves and also process payments to/from the CCP.

CCP clearing results in fewer counterparties to deal Greater opportunity for trade compression and therefore need for with for clearing brokers internal processes for achieving the same

Trends - The Cognizant View

The trend in the OTC derivatives market is towards central counterparty clearing of an increasing number of

product types. As discussed, this clearly benefits the market as a whole. However, it also makes it imperative for

market participants to develop internal processes that will be required by this shift to central counterparty clearing.


Standardisation of OTC derivatives:

Central counterparty clearing involves the clearing

house becoming a counterparty to both the

participants of the original trade. To mitigate the risk

of default by any of these parties, the clearing house

charges an initial margin requirement. Additionally,

the trades are marked to market daily and any

variation in the NPV results in the clearing house

demanding variation margin from one of the parties

and transferring it into the account of the other. The

margining process necessarily requires the clearing

house to be able to perform a risk assessment and

daily valuation of the trade using market data. This

process requires standardization of the products

which the clearing house can support.

The implication is that trading and risk management

systems used by market participants must be able

to process the standardized products supported by

clearing houses.

Increasing the number of products eligible for clearing

Due to the benefits of central counterparty clearing,

clearing houses are standardizing products and

making more products eligible for clearing. This means

that clearing houses are offering to intermediate a

greater variety of OTC derivative trades. As we have

already seen the benefits of CCP clearing, this trend

will clearly encourage higher volumes in such trades.

When buy-side firms i.e. non-market makers trade

with a bank, banks usually provide reports to the

clients that inform them of the trades undertaken

by them. Any processes developed in this regard by

banks may have been designed taking into account

bilateral trades. However, with the clearing house now

becoming a counterparty, the reporting process will

need to be upgraded to recognize the fact that the

client was the original counterparty of the trade.

Additionally, banks will need to develop processes for

reconciling their trading activity with reports provided

by the clearing house. In this regard too, the fact that

the counterparty gets amended from the client to the

clearing house will need to be taken into account.

Development of consolidated trade repository for

increasing number of asset classes:

Lack of transparency was a major problem with the

OTC derivatives market when bilateral trades were

the norm. Even before the trend of CCP clearing had

caught up, the idea of a consolidated trade repository

for OTC derivative trades was already mooted by

regulators in an attempt to gain some insight into this

usually opaque market.

Inspite of CCP clearing, the onus of sending trade

details to the warehouse will be with the original

parties, as the trade is legally agreed bilaterally

between the parties, and only later is cleared by the

CCP. The trend of CCP clearing is poised to increase

volumes of OTC trades. Hence, if the process to report

trade to the repository was semi automated earlier,

banks may now wish to automate the reporting of

trades to the trade warehouse in a more streamlined

manner.

Default Management Procedures to be specified

by CCPs

One of the major reasons why CCPs became popular

was to mitigate the risk of counterparty default. Hence

it is no surprise that every CCP has a detailed set of

procedures on how a default scenario is handled.

Typically defaults by a clearing house member are

handled by either transferring out certain positions

to backup counterparties, or by auctioning off the

portfolio of the defaulting member to the other

clearing house members. The details of this process

are beyond the scope of this paper but the gist is that

clearing house members have certain obligations to

the clearing house in a default scenario.

For instance, members may act as the backup clearing

brokers for certain clients and if the clearing broker

for those clients defaults, the backup clearing broker

may be required to take up those positions into its

books after LCH transfers the appropriate amount of

collateral into the accepting member’s account. The

clearing house also often makes it mandatory for all

members to bid for a defaulting member’s portfolio,

and if such a bid by a member emerges successful, the

winning member would need to update its books with

the new trades. Additionally, members who have been

designated as backup clearing brokers by clients may

want to develop tools that help them quickly evaluate

the portfolios they may be asked to take over, in case

of a default by another member. Such tools help in

taking optimal decisions regarding whether to accept

another client’s portfolio in whole.

It may well be true that default is an uncommon

scenario and as such, members may not find it of

value to invest a lot of effort into automating the

entire process involved in taking up new positions

assigned to them, due to default by another member.

However, at the minimum, internal processes need to

be developed so that when meeting clearing house

obligations, a member can update its books and risk

management systems appropriately to reflect the new

positions taken on.


Post trade events

In the case of bilateral trades, post trade events were

a simple case of one party initiating a trade event and

the other affirming the same. For CCP cleared trades,

though the process remains principally the same, the

trade has to declear for the post trade event to take

place and then reclear (if the amended trade is still

clearing eligible). This means that an STP process

at a bank that worked well in processing post trade

events on bilateral trades will not in general, be able

to process post trade events on clared trades, without

an upgrade.

On an independent note, the fact that OTC trade

volumes are expected to rise as a result of the benefits

of CCP clearing itself suggests that banks may want to

invest in infrastructure to STP post trade events even

if they currently process these manually.

Backloading / Backclearing of trades

With the onset of OTC clearing, most parties find it

beneficial to clear an eligible trade through the CCP.

It is therefore quite likely that clients would want to

clear their existing bilateral trades. Such bilateral

trades may well have been processed through paper

affirmation. Since CCPs require trades to be on

an electronic platform, there are two steps that a

bank needs to perform to get these trades cleared by

the CCP.

a. Backloading: This step involves creating an

electronic version of the bilateral trade based on

the paper documentation of the trade.

b. Backclearing: Once a bilateral trade is created on

the electronic platform, the trade is converted to a

Triparty trade and sent to the Clearing Broker. The

Clearing Broker may be the original market maker

(EB) itself or another bank. The Clearing Broker

intermediates the trade and ends up creating

two bilateral trades (with the EB and the client

respectively). These two trades are then sent to

the clearing house to be cleared. (The process of

clearing a client trade i.e. where the counterparty

is not a clearing house member is discussed later

in this paper)

As there may be a large number of historical bilateral

deals which may need clearing, banks will need to

build internal processes that enable them to backload

and backclear in bulk.

Automated step-in by Clearing Brokers

Volumes on OTC derivative trades are set to increase

with the advent of CCP clearing. Though this would

mean a healthy market and more business for clearing

desks , it also means that the affirmation process by

a clearing broker needs to be automated to enable

STP and facilitate processing of large trade volumes.

Consider a triparty trade involving an Executing

Broker and a client that is addressed to a Clearing

Broker. The clearing broker would typically want to

check that the trade is eligible for CCP clearing and

would also want to check its own limits against the

Client – EB pair. Both these steps may likely have been

done manually as long as trade volumes were low.

However with higher trade volumes, it is imperative

that these steps be automated so that the Clearing

Broker can auto-affirm on the electronic platform if

an incoming trade is found to meet all eligibility and

limit criteria.

Upgrade of Risk Management Systems

Trades in complex derivatives were low in volume

until the advent of CCP Clearing. Hence some market

participants may not have felt the need to invest in

risk management capability to deal with such trades

nor in developing the capability of daily valuation

of such trades. Such trades in relatively complex

products will increase in volume thanks to the higher

liquidity and default risk mitigation introduced by CCP

Clearing. This does mean that banks need to upgrade

their risk management systems to specifically deal

with these products and produce accurate daily MTM

values so that the bank’s overall portfolio risk is

accurately reflected.

Upgrade of Collateral Management System

Traditional bilateral trades were rarely marked to

market on a daily basis. CCP cleared trades are,

however, marked to market by the clearing house

daily and accordingly parties are either paid collateral

or asked to deposit collateral. This requires banks

to monitor collateral requirement feeds from the

clearing house and process collateral payments when

necessary. An additional complication arises in the

case of the CCP Clearing of client trades i.e. trades

between a bank (clearing house member) and a

client (who is not a clearing house member). In this

case, if the client’s NPV drops, the bank has to first

raise a collateral demand from the client and then


pay this received collateral into the account opened

for clients by the bank at the clearing house. To be

able to monitor and process collateral payments for

a high volume on a daily basis, a capable Collateral

Management System is absolutely necessary for

clearing house members.

Dealer side compression

In the absence of CCP Clearing, a Clearing Broker(CB)

typically got involved in two equal and opposite trades

– CB vs. Client and CB vs. Executing Broker. Thus a

Clearing Broker with good volumes would have a large

number of trades against various Executing Brokers

and these would all need to be settled individually.

CCP clearing for trades in Credit and Rates trades

means that after clearing of the dealer side trade

at the clearing house, the Clearing Broker faces

the clearing house irrespective of who the original

Executing Broker for the trade was. This provides

the opportunity to reduce trade processing costs by

clubbing together, where possible, a large number of

dealer trades, given that the counterparty for all of

them is now the Clearing House.

Dealer side compression is more easily undertaken

for CDS trades as there are a lesser number of

parameters (other than counterparty) that need to

match for successful netting in the case of CDS trades

than in Interest Rate Swap trades. To achieve dealer

side compression, the Clearing Broker may need the

following capabilities:

• Identifying sets of trades in the portfolio which are

amenable to compression

• On identifying the set, the Clearing Broker should

be able to unwind the individual trades in their

systems and book a single trade to replace them

• The Clearing Broker should be able to interface

with the Clearing House for the purpose of

agreeing trade compression

• The client trades corresponding to the dealer

trades that were compressed may or may not

need to be compressed depending on whether the

client opts to replicate the compression for their

own trades.

About Cognizant

Cognizant (Nasdaq: CTSH) is a leading provider of information technology, consulting, and business process outsourcing services, dedicated to helping the world’s leading companies build stronger businesses. Headquartered in Teaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industry and business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50 delivery centers worldwide and approximately 104,000 employees as of December 31, 2010, Cognizant is a member of the NASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 1000 and is ranked among the top performing and fastest growing companies in the world.

Visit us online at www.cognizant.com for more information.

World Headquarters

500 Frank W. Burr Blvd.Teaneck, NJ 07666 USAPhone: +1 201 801 0233Fax: +1 201 801 0243Toll Free: +1 888 937 3277Email: [email protected]

European Headquarters

Haymarket House28-29 HaymarketLondon SW1Y 4SP UKPhone: +44 (0) 20 7321 4888Fax: +44 (0) 20 7321 4890Email: [email protected]

India Operations Headquarters

#5/535, Old Mahabalipuram RoadOkkiyam Pettai, ThoraipakkamChennai, 600 096 IndiaPhone: +91 (0) 44 4209 6000Fax: +91 (0) 44 4209 6060Email: [email protected]

© Copyright 2011, Cognizant. All rights reserved. No part of this document may be reproduced, stored in a retrieval system, transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the express written permission from Cognizant. The information contained herein is subject to change without notice. All other trademarks mentioned herein are the property of their respective owners.

otc trading - impact of ccp cognizant white paper

Documents